A geopolitical fog has enveloped the stock market. Three things investors should do now
Key Points
- The war in Iran is driving uncertainty and clouding the economic outlook.
- Volatility, supply risks, and policy uncertainty raise the chance of a market sell-off.
- Investors should reduce risk, raise cash, and stay cautious until the fog clears.
The fog of war describes a situation where soldiers in the heat of battle become disoriented, lose contact with their unit and even fail to distinguish friendly forces from enemy combatants due to uncertainty created by the inability to see the whole battlefield and the fast-paced nature of fighting. It can lead to poor and often deadly decisions. On rare occasions a fog envelops the investing landscape leaving the future fraught with uncertainty. That is where we are now. Investors should be focused on three things right now: Evaluating their portfolio risk Raising cash Waiting for clear positive developments on the war. The war in Iran has created a huge amount of uncertainty. Some of its effects have already become readily apparent. Everyone already has seen an increase at the pump in gasoline prices, but it’s not just oil production that has been disrupted. Potential shortages in helium, aluminum, fertilizer, natural gas and pharmaceuticals could affect the price of a new car, cell phone, drugs and even everyday food staples. After several attempts to bounce this week — including a late rally Thursday on nondescript comments from Israel Prime Minister Benjamin Netanyahu — the S & P 500 closed lower for a fourth-straight week and the Nasdaq Composite Index fell nearly into a 10% correction. If prices are pushed high enough for long enough it could lead to demand destruction, a long-term decrease in consumption that often causes a recession. We are already seeing the potential signs with base metals such as copper seeing significant selloffs this week. @HG.1 YTD mountain Copper futures, YTD Federal Reserve Chairman Jerome Powell’s recent comments at a press conference following the Fed’s interest rate decision reflected this sentiment. The chairman acknowledged his uncertainty about how tariffs and elevated oil prices may affect inflation and the course of monetary policy. He even urged investors to take the FOMC’s quarterly rate and economic forecasts with a “grain of salt,” as they are “subject to high levels of uncertainty.” JPMorgan analysts believe investors are pricing in “a quick end to the Middle East conflict and reopening of the Strait, giving a low probability to a potential demand hit.” But investors cannot just consider the most likely or base case, they must also weigh the possibility of more dire, although less likely scenarios. The Israeli attack on Iran’s South Pars gas field on Wednesday marked a significant escalation in the war. Not only will it extend the expected length of the war and lead to retaliation (which we have already seen with Iran’s attack on Qatar’s Ras Laffan Industrial City, the largest liquefied natural gas export facility in the world), but it was the first such attack on upstream production assets that can take much longer to repair than previous attacks on energy storage facilities would. If there is significant damage to energy infrastructure in the Middle East, it could take years to come back online even if the hostilities quickly de-escalate. Consider cash When volatility rises it behooves investors to avoid leverage and think about raising cash. Cash can provide investors with a temporary safe haven and optionality if markets do suffer steep declines. Some professional investors have already begun to adjust. According to a Bank of America survey, fund managers have increased their cash levels to 4.3% from 3.4% last month, the sharpest increase since the Covid sell-off in March 2020. These levels are now approaching more average levels after flirting near record lows. That means the rush to cash may not be over. In a recent note, Deutsche Bank analysts suggested “longer-term investors are yet to shift positions much, so an unwind could come if the shock continues.” JPMorgan echoes this sentiment saying, “investors have been mostly hedging rather than de-risking, with gross leverage still near highs (~95%tile),” The longer the war goes the more likely such a shock will happen. Time, in this case, is no longer on investors’ side. Investors now need to worry about weekend risk. Usually, if there are no major geopolitical developments over the weekend markets are apt to recover the following Monday. Now three days with no news, means three more days of significant supply imbalance. Watch the ‘VIX’ The Cboe Volatility Index (VIX) can give investors a good idea of how much uncertainty there is in markets. Its median value since 1990 is about 17.6, but it currently stands at around 28. Values between 20 and 30 are a sign investors may be nervous about the future. Readings above 30 usually indicate some sort of panic is beginning to develop. .VIX 1Y mountain The Cboe Volatility Index, 1 year Investors require higher returns for higher risk which means that multiples must contract. The S & P 500 is currently trading at 20.5x its next-twelve-months earnings, a multiple many investors may be unwilling to pay given the current uncertainty. JPMorgan has lowered its end-of-year target for the S & P 500 index to 7,200 from 7,500 due to the potential geopolitical overhang. Use the market bounces Technically markets look oversold and could be due for a bounce, but a rebound that doesn’t come with news that tankers are beginning to move through the Strait of Hormuz should be looked at as an opportunity to lighten up on stock risk or shift some exposure to sectors like defense and oil and gas. The return to normal shipping traffic through the Strait is likely the only development that will lift the current fog. That would likely take some of the most pessimistic scenarios off the table for stocks. Until then investors with shorter time frames measured in months or a few years need to put risk considerations at the forefront of their trading decisions.
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